What is Stop Loss in Stock Market & How to Use it?

What is stop-loss and how is it used?

Meet Vinod. He is a beginner in the stock market and wants to understand the concept of stop-loss. His friend Ashish, an active trader with Angel One explains:

Stop-loss is a method used by an investor to limit his losses. It works as an automatic order given by the investor to his broker to sell a security as soon as it reaches a certain predetermined price. For example, let’s say Ashish buys 50 shares in ABC Mobiles at the rate of one thousand rupees per share. Shortly, the share price falls to 960 rupees per share. Ashish wants to limit his losses; so he inputs a stop-loss order at nine hundred and fifty rupees. If price corrects further to nine hundred and fifty rupees, his broker Angel One will sell the shares to prevent further losses.

On the other hand, if the share price jumps to oshane thousand four hundred rupees per share, Ashish would want to hold on to his shares and not lose his advantage; so he inputs a stop-loss order to sell the shares if the price falls to one thousand three hundred rupees. By placing the stop-loss order, Ashish protects his investments by retaining his gains and preventing potential losses.

How to Set Stop Loss Levels? 

These are the factors to consider before setting a stop loss.

1. Risk assessment: Assessing the risk tolerance level before setting the stop-loss level, i.e., determining the percentage of your investment you can risk losing on a single trade. This will help you select the stop-loss level. 
2. Liquidity of stocks: Consider the liquidity of the stock before trading. Sometimes, while trading in low-volume stocks, even if you place a stop-loss level, you may not be able to exit the trade because there is no buyer on the other side.
3. Position size: If you are trading a large position, executing your trade can be difficult if it is a low-volume stock. Therefore, be careful while deciding the portion size.
4. Volatility consideration: More volatile stocks would need a wider stop-loss to avoid the trade being executed prematurely. Similarly, you can trade with a tight stop-loss limit while the stock is less volatile.
5. Determine the proper stop-loss level: Use technical analysis to determine support and resistance levels, trendlines, moving averages, and other key indicators that can help you set stop-loss levels. It is a common approach to set the stop-loss below the support level to allow room for fluctuations. 
6. Average True Range (ATR): ATR can help you decide the appropriate distance of your stop-loss level. ATR is a measurement of a stock’s volatility, including any price gaps. Setting your stop loss at multiples of the ATR is a common practice. 
7. Market condition: Be aware of the overall market condition before placing your stop-loss. If the market is highly volatile or you expect big news regarding the company/sector, you may place a wider stop-loss, to avoid missing out on any trading opportunity.  
8. Backtesting: Before implementing the stop-loss, backtest it using historical data and different market conditions. Traders use the strategy to fine-tune and test the validity of the stop loss level.

One of the common methods to determine stop loss is the percentage method. Also, when you have placed the stop loss, stick to it and avoid making emotional decisions.  

Advantages of using stop loss

• Minimise losses: By using a stop loss limit, traders can minimise their risk and protect their trading capital from suffering significant losses.  
• Improve risk management: Stop-loss is a risk management strategy. Traders can improve their overall trading gains by using a stop loss and achieve their investment goals. 
• Avoided emotional decisions: The stop-loss will take the emotions out of decision-making. It prevents bad decisions and helps traders avoid impulsive decisions that can negatively impact their trading outcomes.

Disadvantages of Using Stop Loss

• Volatility: In a highly volatile market, a stop-loss can be triggered by short-term price fluctuations and result in premature exits. 
• Slippage: Slippage is a situation where the execution price differs from the price set for the stop-loss. Hence, even if the stop loss is triggered, it may not get executed at the exact price. 
• Gappings: There can be incidents when the price can take a hop and skip your stop-loss limit, as it often happens during events of significant market news or events.
• Psychological impact: Constantly monitoring and adjusting the stop loss level can lead to stress and anxiety. 

Importance of Stop-Loss Orders

Stop-loss orders play a critical role in investment strategies by offering investors a predetermined exit point to limit potential losses. They provide a safety net, especially in volatile markets, where prices can fluctuate rapidly. For risk-averse investors, stop-loss orders offer peace of mind by automating the process of selling if the price of a stock falls to a specified level. This allows them to protect their capital without needing to monitor the market constantly.

Moreover, stop-loss orders help investors adhere to disciplined trading practices. By setting a limit on losses, investors can manage their risk exposure effectively and avoid emotional decision-making during market downturns. This disciplined approach is essential for long-term wealth creation as it prevents catastrophic losses that could derail financial goals.

Limitations of Stop-Loss Orders

Despite their benefits, stop-loss orders have inherent limitations that investors should be aware of. Firstly, they do not consider fundamental market analysis or company-specific factors. A stop-loss order solely relies on price movements, which may not always reflect the underlying value or future potential of a stock.

Secondly, during periods of market volatility or low liquidity, executing a stop-loss order at the specified price may be challenging. This can result in “slippage,” where the actual execution price is worse than the stop price set by the investor, potentially leading to larger losses than anticipated.

Thirdly, in extreme market conditions such as rapid or flash crashes, stop-loss orders may not adequately protect investors. Markets can experience sharp declines beyond the stop-loss level, causing significant losses before the order can be executed.

Despite these limitations, stop-loss orders remain a valuable risk management tool when used judiciously alongside comprehensive market analysis and a well-defined investment strategy.

Final Words 

A stop-loss is a useful risk-mitigating tool. By setting predefined price points for stop-loss, traders can mitigate potential losses and protect their investments from volatile market movements. Implementing stop-loss strategies empowers traders to strike a balance between profit potential and safeguarding capital.

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